By the close of 2019, the stock market had recorded a 22.3% increase in the Dow 30 Industrials with the S&P 500 at 28.9%, and the NASDAQ at 35.2%; making 2019 a really good year for the stock market compared to the previous year. There was more optimism as the market approached the new year, considering the fact that the Fed willingly reversed itself all through 2019. Despite the optimism for the stock market’s performance in 2020, concerns about its sustainability could not be overlooked.
The first few days 2020 seemed to favor the market with companies like Tesla experiencing a stock pop. As of January 14, it was reported that a stock market correction is only around the corner. Contributing to this possibility is the current overvalued state of the U.S. stock market. Failure to successfully stabilize the market can develop into a market crash.
What is a Stock Market Crash?
A stock market crash can be defined as a drastic drop in the stock index within a day or two of trading. The stock indexes are the NASDAQ, S&P 500, and the Dow Jones Industrial Average. Crashes usually happen at the end of a prolonged bull market, and they are more sudden than corrections. Crashes can be caused by frightened sellers who feel threatened by an unexpected economic catastrophe. They can also be caused by multiple overpriced stocks. That is, stocks increasing far beyond their real worth measured by the companies’ earnings. It is basically when the price-to-earnings ratio is higher than the expected average. Quantitative trading— trading stocks through the use of mathematical algorithms computer programs—is another factor that can cause a market crash. Using the quantitative trading technique hedge funds and sophisticated investments numerous computers are programmed to sell at the occurrence of specific events. Quantitative trading systems are also prone to technical malfunctions. For example, the May 2010 flash crash where the Dow Jones Industrial Average fell about 1,000 points within a short time.
What is a Stock Market Correction?
A stock market correction is when the stock declines from its most recent high by 10% or more. If the percentage exceeds 10% and gets to 20% or more it is called a bear market. Though the U.S. stock market has long experienced the bull market, it has had a total of 37 stock market corrections between 1980 and 2018. It is normal for corrections to occur as they usually occur every 8 to 12 months lasting about 54 days. Corrections are not only limited to the central market but can also occur in individual stocks and individual indexes.
The correction for the S&P 500 in 2018 lasted about four months with a 13% drop in value. New investors or individual investors who are not quite conversant with market corrections tend to panic at the slightest drop or 10% or more of the market value. There is also the fear of uncertainty of when the market would likely recover. While for sophisticated investors and institutional investors the correction is seen as an integral part of the stock market. It is also possible that if not controlled on time, a correction may slide into a crash which may take a longer time to recover. There are also instances where short-term traders or day-traders amass great losses during corrections as a result of a sudden correction occurring during one trading session.
Stock market corrections can be said to be healthy for both the market and its investors. For the market, they can help recalibrate and readjust overvalued assets that make the market overvalued as well. And, for the investors, corrections provide an opportunity for them to take advantage of buying stocks at discount prices and have a firsthand experience of uncertain events that can likely cause the market to suffer. For the novice or new investors, it also teaches them a valuable lesson about the twists and turns of the market, and how to prepare for the next time.
Is it safe to invest during a stock market correction?
Though a correction hit affects the whole market the effect on some equities are more intense than the others. For example, smaller-cap and high-growth stocks in high volatile sectors are more likely to be affected by a correction. Compared to higher-cap stocks which can still perform even when the market slides into the bear territory or crashes. During a correction individual assets tend to perform poorly contrary to their overperforming state before the market correction. For traders or investors looking to buy assets, the correction period may seem like the ideal time to buy overvalued assets at low or discounted rates. Still, such investors must weigh the risks involved with buying assets during the correction as the turn the market may take or when the correction may end are uncertain. The investors would then have to put in a lot of effort would have to be put into protecting their investments. It may be quite tedious but totally achievable by setting up a stop-loss order or stop-limit order to deal with falling equity prices. Stop-loss orders are automatically triggered when the price gets to a certain level the investor pre-sets. It guarantees execution. While the stop-limit orders set a specific target price and an outside limit for the trade. It guarantees prices.
There are no fixed rules for investing during the stock market correction. If your risk tolerance can handle it then, by all means, proceed with investing. If otherwise, then it is probably best you allow the market to stabilize first. There may be no general rules to investing during a correction but there are a few tips to guide you.
Tip: When investing during a correction, diversification may come in handy by providing some form of protection if assets that perform contrary to those being corrected or assets that can be influenced by different factors are involved. That way when one investment vehicle suffers the others can still cover your investments until the correction season is over. Though a 10% drop can greatly affect investment portfolios.
Pros and cons of investing during a correction
Investing during a market correction is not for the faint of heart. It both holds perks and disadvantages.
Predicting a Correction
Using market analysis, analysts are able to compare market indexes with each other that way they are able to notice an underperforming index which is closely followed by another underperforming index. When there is a frequent occurrence of this, it is a good sign that a market correction may be lurking around the corner. Another way to analyze the market for corrections is through the use of technical analysis. It analyses resistance level and price support to be able to predict when a consolidation may turn into a correction. The process of analyzing the market is called ‘charting’, and analysts use it to track changes in an index, asset or the market over time.
Expecting a Correction
There’s only little analysts, investors, and traders can do about the occurrence or outcome of a market correction, however, as an investor there are things you can do to prepare for a correction. And with the current turn of events in the stock market, now seems like a good time to prepare for a market downturn.
Previous Market Corrections
The U.S. stock market has experienced 37 corrections in total from 1980 to 2018. All through, the S&P 500 dropped by an average of 15.6%. Market corrections hardly slide into bear territories, but a total of 10 of these corrections ended up in bear market meaning that the market suffered a great economic meltdown. While the other 27 corrections successfully transitioned back into bull markets which reflect economic stability and growth. The U.S. stock market has run an extended period of a bull market.
In 2018, in the first quarter of the year, two of the major stock market indexes, the S&P 500, and Dow Jones Industrial Average experienced corrections falling above 10%. And by the fourth quarter of the year, the Nasdaq and S&P 500 experienced another correction falling by over 10%. Before the close of 2018, precisely December 17, Dow Jones and S&P 500, once again fell over 10% with the S&P dropping by 15% from its all-time peak.
Current Market Correction Possibilities
The new year is only gone by a few days, yet possible threats of corrections seem to lurk around the corner. By the end of 2019, market analysts revealed the tendencies of the market experiencing a correction in 2020. The U.S. stock market has not only greatly increased in value but has “quickly expanded throughout the past six months without a sizable correction.” Only a few days ago, the chief investment officer at Sunrise Capital, Chris Stanton predicted that by March 31, 2020, the stock market is expected to drop by 18% to 20% in the S&P 500. In his words, “Rest assured, we’re heading for a correction and I would argue it’s going to be terrifying when it comes.” He backed up his predictions by stating already existing risk instances in the market— “The geopolitical situation is far from resolved, volatility is mispriced, and nobody knows what’s going on in repo markets.” There is a great concern for additional tariffs, and a possible fall out in the China trade deal mostly as a cause of geopolitical tension.
In the 2019 Q4, major U.S. companies began to significantly surge in their valuations, and only last week, Tesla Motors caught up with this surge. The strong stock's surge has since led to the rapid increase of the price to earnings ratio (PE) of most companies. The PE ratio reveals the overpriced state of the U.S. stock market, and stock market strategists have duly stated that due to the proportional increase in the price of stocks the U.S. market long overdue for a correction.
A lot of stock market analysts and strategists have stepped forward to predict the likelihood of a correction while that is non-negotiable considering the overvalued state of the U.S. stock market, other predictions like stock market crash are likely not to occur. There are still some predictions about the U.S. stock market that have gone out, and we’ve been able to capture a few.
These may seem as just mere predictions but they can be looked out for all through the year.
Stock market corrections are expected and normal as they can help maintain a balance in the market They can also lead to a market crash if not properly and quickly controlled. An average correction can be sustained for three to four months. Stock market analysts, investors, and traders predict the market by using charting methods. There may be no exact details on when a correction may start or end, or the extent to which prices may drop by the end of the correction. The only thing analysts can do is to take study the data of previous corrections and plan around that. Generally, issues that arise from corrections differ by the stocks or indexes they affect, and they can be triggered by macroeconomic shifts that concern the whole market or a change in a slight company’s management structure.